Quality of Earnings in Medical Practices

Quality of Earnings (QoE) is an analytical tool healthcare intermediaries and business valuation experts use in determining a medical practice's value. QoE analysis helps the healthcare intermediary focus on the practice's activities that represent a truer picture of the practice's value to the owner. The analysis highlights how sustainable, replicable, and representative a practice's reported profits are. It goes beyond standard accounting statements which can distort the economic view of the practice.

Characteristics of high QoE includes:

• Sustainability. Core practice activities that generate recurring revenue.

• Predictability: Core practice activities that have demand the practitioner can readily forecast.

• Strong Profits to Cash Flow Correlation. Reported profit trends directly relate to the operation's cash flow generating ability. Minimal adjustments or interpretations needed.

• Low Risk. Minimal variability in earnings and cash flow streams.

Characteristics of low QoE includes:

• One-Time Gains. Reported income inflated by non-operating income (e.g., asset sales) and unusual income credits.

• Aggressive Accounting. Manipulation of revenue recognition method and expense deferrals.

• Unsustainable Trends. Uncontrollable actions (e.g., regulatory changes, market disruptions) materially drive profits and expenses.

• Weak Cash Flow. Reported income indirectly related to cash flow.

Most healthcare intermediaries conduct a QoE analysis of a practice by normalizing operating income. Operating income is normalized by adjusting reported operating income by:

• Excluding non-operating income (e.g., rental income)

• Excluding one-time charges or credits (e.g. legal fees, unusual credits, sale of equipment)

• Reducing or increasing reported owner's salary to reflect the market value of the services provided by the owner (e.g., increase salary expense if practitioner is not drawing enough out of the practice)

• Reducing or increasing reported facility rent to reflect the market value of the space used (e.g., charge a rental rate for the amount of space the practice is actually using, even if the practitioner owns the office space).

• Excluding personal expenses that do not related to generating income for the practice (e.g., take out the Ferrari lease)

• Including salaries for all persons contributing services to the practice but not taking a salary (e.g., typically a working spouse).

• Adjusting any other revenue or expense that do not contribute to operating the practice.

Quality of Earnings analysis and the subsequent adjustments it recommends for practitioners can increase the practice's value by (i) making financial statements more reliable, (ii) reducing the variability in the earnings streams, and (iii) demonstrating that the practice is well-run.